Essays

As we noted earlier, a market is defined by the consumers. Suppliers cannot change the amount of money consumers have to spend or want to spend. What suppliers can do is compete with each other within this marketplace. In essence, in the two tier graph, consumers are represented by the upper tier, suppliers by the lower tier.

The individual people involved have no say in this. As long as people in general tend to spend less when prices rise, and tend to spend more when prices decline, the rest of the analysis is set in stone. If people always spend the same amount of money on something, regardless of price, then this analysis fails. As long as the consumer demand curve is not a square hyperbola, then mathematically there must be some point of tangency between the consumer demand curve and some square hyperbola, and thus there will be a single point of maximum revenues (Rmax) and that will create a single point of maximum profits ($max) for businesses.

But up to this point we have assumed only one supplier to the market. A single supplier will always seek to set the price for any product or service at the point of maximum profits. But between the two points of maximum profits and maximum revenues are numerous price levels that result in greater total revenues but lower total profits. Lower prices result in higher total revenues but lower total profits.

If there are two or more firms in the marketplace, each receives part of the consumer spending. One firm may dominate and get nearly all the spending, or the firms can evenly divide up the spending, or any combination in between. Typically, in mature markets, one large firm will dominate with a large share of the spending but not a majority, while two smaller firms also have large shares, and the rest of firms divide up the rest. This occurs because typically one firm develops a product or service that serves as the generic standard for that market, the two smaller firms offer competing standards, and the rest of the firms tend to customize the products of the top three for niche markets.

But to understand how competition works, let us begin with just two firms, company A and company B, that divide up consumer spending about equally. Both firms have set their price at the point of maximum profits, and the two firms divide the profits equally. However, if one firm decides to charge a price lower than the price of maximum profits, consumers may decide to spend more of their money at this firm. A lower price results in lower total profits, but firm A might decide to do so in order to garner a larger share of these lower profits. It is very possible for one firm to have higher profits with 60 percent of a smaller profit pool than 50 percent of a larger profit pool.

If consumers purchase more from a supplier offering lower prices, then that supplier will see both revenue and profits increase, but that increase in profits results from a greater share of a smaller profit pool. If all of the firms decide to match the lower price of company A, the result will be more revenues and lower profits to divide up by the same proportion. A lower price means that firms can increase the income they receive because consumers spend a larger share of their money the closer price moves toward Rmax. Still, by seeking higher revenues, firms move away from the point of highest profits.

Even with two identical businesses, one can charge a lower price in order to increase sales and get a greater individual profit. Thus competing firms will stray into the territory between maximum profits and maximum revenues. They are inclined to do this because even if total profits decline, the increase in revenues gives firms a false signal of improving circumstances.

The reality of the marketplace is that individual firms will seek to maximize THEIR profits by grabbing greater marketshare while collectively they minimize total profits. From the economy's view, competition causes lower prices which results in consumers spending more money, while saving less money, and total profits to businesses decline. Intense competition can actually drive firms collectively to the point of maximum revenue where there are still profits to divide up, but consumers spend all of their money and no longer save any money while total profits for all firms has fallen.

It is ironic to hear economists laud the competition of the American economy and then lament the lower savings rate of American consumers. The two are mathematically equivalent. It is akin to praising the high prices for bonds and then lamenting the low interest rates. The less competitive the economy, the greater the total profits of firms and the greater consumer savings. This also means the greater the amount of investment available from consumer savings and the greater profit incentive there is for more new firms to enter the marketplace.

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